Cuckoo for cocoa futures

Cocoa is building bullish technical energy highlighted by an ascending wedge formation that reflects a coiled spring preparing to release an explosive move. The MACD recently has triggered a buy signal, increasing the odds of a breakout over the next several months (see “Hot chocolate”).

The breakout, should it occur, will be explosive, but the technicals are not the only reason to be bullish cocoa. The long-term structural supply/demand imbalances that have created a series of recent deficits are not going away anytime soon. In 2010, Mother Nature was unusually kind but, because of the aging tree population in the Ivory Coast and the depleted soil content in Ghana, such favorable weather will not produce record crops and likely will produce a global deficit in 2011.

Recently, many high profile cocoa analysts have downgraded global cocoa production as good weather was overplayed and the deleterious effects of decades of lack of investment in the cocoa industry were underemphasized in their analyses, leading to overly optimistic global production expectations.

The International Cocoa Organization (ICCO) recently has increased deficit expectations for the 2009-2010 marketing season. The likely probability for 2011 is that weather becomes normal to adverse and sets global cocoa production back into a major tailspin, leading to shortages of high quality cocoa. With demand for this kind of cocoa strong and demand growth expected apace, record highs are a matter of when, not if.

We have seen the cocoa market move well above $3,000 per ton over the last several years without generating the kinds of investments that are desperately needed to rejuvenate long-term global production. Additionally, there has been very little demand degradation during these spikes. It will take much higher prices to accomplish a more balanced cocoa trade, especially against the increasingly economically competitive alternative markets for growers, such as rubber, palm oil and coffee.

Is it any wonder that processors and merchants have loaded up on cocoa futures to hedge against a likely price spike in future years? The people that know more about the cocoa trade than anyone else see much higher prices on the horizon.

Commercial operators tend to hold near-record long positions at major bottoms as they rush in to protect upside price risk. If you look at the times that commercial net longs have risen to the levels we have today, they have been followed by bull moves. It has been profitable for investors to follow the commercial net positions and buy when they have become historically long.

With Intercontinental Exchange US (ICE) certified warehouse cocoa stocks being drawn down over the last six months to some of the lowest levels seen since 2009, and with near record cash premium differentials against futures, the fundamentals remain very bullish. Add that to the bullish technical and commercial signals, and cocoa can make an historic move.

Another piece to consider when analyzing potentially major turning points is relative value. For cocoa, two of the most important relative value measures — the cocoa/CCI (Continuous Commodity Index) price ratio and the cocoa/sugar price ratio — are flashing major long-term buy signals. Both measures are at some of the lowest levels seen over the last 40 years, and low levels typically have preceded major bull market moves.

Cocoa has a history of being a rogue commodity with, at times, very little correlation to the rest of the commodity complex. This is important as we may be facing an extended commodity correction, but the cocoa market could still see a major bull run.

The initial margin requirement for cocoa futures is $1,610 per contract, making it one of the more affordable commodities to trade. Front-month cocoa closed at $2,758 on Dec. 1. A trader could get long in that area with a protective stop placed at the Sept. 13 low around $2,600, proving a better than 3:1 risk/reward ratio. A tighter stop can be utilized following the bottom trendline which, as long as it holds, supports a long position. Look for opportunities to buy March 2011 cocoa on any correction that takes prices under $2,800 for an eventual move up to the $3,400/ton area in 2011.

With the technicals, fundamentals, commercials and relative value measures all aligning with historical bullish signals, investors should take notice. And given cocoa’s history of independence, it could be the one commodity to buy in the first part of 2011.

Shawn Hackett, commodities broker and author of the Hackett Money Flow Report newsletter (www.hackettadvisors.com), is a nationally recognized agricultural commodities expert with more than 18 years of money management experience.

About the Author

Shawn Hackett, commodity broker and author of the Hackett Money Flow Report newsletter (www.hackettadvisors.com), is a nationally recognized agricultural commodity expert with more than 18 years of money management experience.